If you are buying a house with less than 20 percent of the purchase price as a down payment, you will need to pay mortgage insurance in one form or another. Mortgage insurance protects the lender in case you default, and allows the lender to offer you mortgage rates comparable to those given to borrowers with larger down payments. Most commonly, mortgage insurance is paid as part of each monthly payment, but there are other ways to structure the mortgage insurance, including the option of rolling it into the closing costs.
Rather than paying mortgage insurance with your monthly payment, you can pay a lump sum at the beginning, thus keeping your monthly payments lower for the future. It is rolled into the costs for closing. The amount due for this up-front fee will vary based on how much of a down payment you make. A 15-percent down payment will require less mortgage insurance than a 5-percent down payment. On a refinance loan, this cost, along with the other closing costs, may be able to be added into the loan amount, to prevent you from having to pay out-of-pocket costs at closing. On a purchase loan, anything you add on to the loan will be considered a reduction in your down payment. If you are planning to put 10 percent down, for example, and then finance your private mortgage insurance, this would effectively raise your loan from 90 percent of the purchase price to 91 or 92 percent. Since lenders base their rules on 5-percent value increments, this could significantly alter both your approval and the cost of the mortgage insurance itself.
Another option is called “lender paid PMI.” In this scenario you receive a mortgage at a higher interest rate in exchange for the lender paying the private mortgage insurance. The lender may pay the lump sum to the mortgage insurer, or it may make monthly payments to the insurer on your behalf, but it is all handled on the back end of the transaction. You will never have to see or worry about the PMI payments yourself.
A Word on FHA Loans
Loans guaranteed by the Federal Housing Administration are a common option for people who have a small down payment. With only 3.5 percent required as a down payment, FHA loans are often used by first-time homebuyers and people with less than perfect credit. FHA has a special kind of mortgage insurance that has both an up-front and a monthly portion. This usually makes an FHA-backed loan more expensive than conventional financing, but the up-front portion can be tacked onto the loan amount without impacting the down payment calculation.
Choosing the Best Option
Which mortgage insurance option to select depends primarily on your time horizon and your balance between the cash you have in hand and your future cash flow. Time horizon refers to the length of time you expect to carry your mortgage. If you think you will pay it off in two or three years, either through sale or through refinance, you may not be paying on the loan long enough to justify the large up-front cost of a lump-sum mortgage insurance payment. If you think you will pay your mortgage for the entire term without ever refinancing, paying the lump sum at the beginning could save you money years down the road. Another possible reason to pay the lump sum is if you have the cash available to do it, but know that your cash flow will be tight while paying your mortgage each month. Paying for the entire mortgage insurance premium at closing will give you lower monthly payments then the other options.
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